Alex Guadet of Forrest City, Arkansas, has been renting a small, two-bedroom hou

Question

Alex Guadet of Forrest City, Arkansas, has been renting a small, two-bedroom house for
several years. He pays $900 per month in rent for the home and $300 per year in property and liability
insurance. The owner of the house wants to sell it, and Phillip is considering making an offer. The owner
wants $130,000 for the property, but Phillip thinks he could get the house for $125,000 and use his $25,000
in 3 percent certificates of deposit that are ready to mature for the down payment. Alex has talked to his banker and could get a 5.5 percent mortgage loan for 25 years to finance the remainder of the purchase price. The banker advised Alex that he would reduce his debt principal by $2200 during the first year of the loan. Property taxes on the house are $1800 per year. Phillip estimates that he would need to upgrade his property and liability insurance to $800 per year and would incur about $1500 in costs the first year for maintenance. Property values are increasing at about 2.5 percent per year in the neighborhood. Alex is in the 25 percent marginal tax bracket.

(a) Calculate the monthly mortgage
payment for the mortgage loan that Phillip would
need.

(b) How much interest would Alex pay during the first
year of the loan?

(c)

Explanation / Answer

a) Monthly mrtgage (Using excel formula):

=PMT(0.055/12,25*12,-125000,0)

= 767.61

b) Interest paid = Monthly payment * 12 - reduction in debt principle

= 767.61 * 12 - 2200

= 7011.32

c) Net cost in rented = (900*12 + 300)*( 1 - .25) = 8325

Net cost if buy = (7011.32 + 1800 + 800) * (1 - .25) = 7208

Buying is better option as calculated above and in addition there will be additional gain of 2.5% due to capital appreciation.

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